CCl lU LAT IN iOY 4 G * C 3 r No. P- 1068 TO BE RETURi,ED TOE RPORTS DESK 0 p This report is for official use only by the Bank Group and specifically authorized organizations or persons. It may not be published, quoted or cited without Bank Group authorization. The Bank Group does not accept responsibility for the accuracy or completeness of the report. INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT REPORT AND RECOMMENDATION OF THE PRESIDENT TO THE EXECUTIVE DIRECTORS ON A PROPOSED LOAN TO NACIONAL FINANCIERA S. A. WITH THE GUARANTEE OF THE UNITED MEXICAN STATES FOR AN INDUSTRIAL EQUIPMENT FUND (FONEI) PROJECT May 10, 1972 ITTERNATIODUL BANK FOR RECONSTRUCTION AMD DEVELOPMENT REPORT AAND RLCOMMEI!DATION 07 THE PRESIDENT TO THE EXECUTIVE DIRECTORS ON A PROPOSED LOAN TO NACIONAL 5INANCIERA, S.A. vITH THE GUARAMTEE OF THE WITED MEXICAiI STATES FOR? AN INDUSTRIAL EQUIPMENT FUND (7'o0EI) PROJECT 1. I submit the following report and reconmendation on a proposed loan to Nacional Financiera, S.A. writh the guarantee of the United Mexican States for the equivalent of $35 million, to finance the foreign component of the lending operations of the Government's Industrial Equip- ment Fund (FONEI). The loan would have a term of 20 years, including three years of grace, with interest at 7-1/4 percent per annum. PART I - BANK LEMDING TO ME7ICO 2. My- report and recommendation dated April 19, 1972, which was distributed in connection with the proposed Bank loan for a ports project, gave recent information on the Mexican economy and its prospects, and summarized the Bank's past and planned activities in Mexico (see Annex IV). As indicated in that report, the port loan and other loans to MNexico planned for presentation during the next few months total over $250 million. After taking into account scheduled repayments during the disbursement period of the new loans, Mexico's total outstanding debt to the Bank would increase by about $143 million (from the present total of about $839 to $982 million at the end of FY1975). If the Bank made no further loans to Mexico and Mexico did not increase further her out- standing external debt during this period the Bank's share in the total would increase from about 20 to 23 percent. However, Mexico will un- doubtedly be borrowing extensively during the coming years to meet the growing external financing requirements of the economy and is looking increasingly to the Bank and the Inter-American Development Bank in order to help meet these needs and improve the maturity pattern of her external debt. 3. In addition to the loans I expect to present for your considera- tion during the next few months, there is a substantial number of projects which are at an earlier stage of preparation or review including projects for rural development and education. Future lending will, of course, depend on progress made in preparing suitable projects, as well as on Mexico's economic performance, particularly in fiscal matters, the balance of payments and investment planning. If the level of Bank lending were to average $200 million per year during the next five years, the Bank's share in Mexico's external debt would increase from about 20 percent at present to 25 to 30 percent by 1980. Mexico faces difficult long- term structural problems arising from a rapidly growing population, the need to improve conditions within rural areas and to start to reduce in- come disparities. At the same time development requires substantial capital which has to come from additional public savings if excessive reliance on foreign borrowing is to be avoided. Given sound fiscal -2- policies the near term prospects of the econory appear favorable. M4anu- factured exports are expected to continue to expand rapidly. External reserves are equivalent to about 5 months imports. Service of the external debt absorbs about 20 percent of exports and non-factor services and is not projected to increase above that level over the next 10 to 15 years. In the light of past performance and present prospects I believe M'exico is creditworthy for the foreign borrowing presently contemplated. At Annex I is a summary statement of Bank loans and IFC investments in Mexico. Country data are at Annex II. PArIT II - THE INDUSTRIAL SECTOR 4. Mexican industry has grown very rapidly since lWorld War II, attaining an average annual growth rate of 8.4 percent per year in real terms in the 1960's, while GDP grew at an average rate of 7.1 percent. About one-fourth of gross domestic investment went into industry during the 1960's and its share in GDP increased from 19 to 22 percent. In 1970 the value of manufacturing production amounted to $19.3 billion. 5. The structure of manufacturing industry has changed considerably over the past 20 years. Rapid increases in output have occurred in heavy industries, such as chemicals, steel and metal-working and slower increases in such older industries as food, beverages, tobacco, textiles and other consumer goods. Nevertheless, the food processing industry remains by far the largest. 6. Wqhile import substitution protected by quantitative import restrictions has had an important influence on industrial growfth, the expansion of M9xican industry has been accompanied by rapidly increasing industrial exports, particularly in recent years. These exports, ex- cluding petro-chemicals, have increased at about 25 percent a year since 1968. Whereas manufactured exports provided only 6-7 percent of commodity exports in 1960, by the end of the decade they had grown to 19 percent of a much larger total. Most of the gains in manufactured exports have occurred in the categories of foodstuffs, chemicals and miscellaneous, which include "modern" items, such as electronics and automotive parts. The old and large textile industry has been a noticeably weak contri- butor to exports in recent years, reflecting not only the U.S. import quota on texctiles but also high costs and the absence of any special design appeal in markets abroad. Government Priorities 7. W4hile the growth of industrial exports has been accelerating, extport growth as a Twhole has slowed down in recent years. The balance of payments deficit has widened substantially and has become a serious threat to continued rapid economic development. Accordingly, the Govern- ment of President Echeverria has, since it assumed office in December 1970, been giving high priority to measures designed to attack this problem as part of its policies and programs. -3- 8. To aid in export expansion a number of new guidelines were issued in 1971 to stimulate "in-bond" and "border" industries and a comprehensive set of export incentives was introduced. These incentives, which add up to about 13 percent of production costs, include (a) duty free temporary imports of machinery, equipment and materials for export- oriented assembly plants, (b) refund of duties levied on imported inputs and (c) the refunding to firms producing for export of a portion of their domestic Federal income taxes in the form of non-transferable tax certi- ficates valid for five years and usable to pay most Federal taxes. Eli- gibility for these refunds was subsequently extended to trading companies and a number of such companies have already been set up. A Foreign Trade Institute has also been established to help industrialists in developing markets abroad. Furthermore, the Government has established a new insti- tution (FONEI) to help finance fixed investment mainly for export enter- prises, supplementing the already existing export aid in the form of export credits provided since 1964 by FOMEX and export credit guarantee insurance under a system which was introduced in 1970. 9. In addition to these new measures directed specifically at export promotion, the Government has also initiated several general policies designed to strengthen industrial efficiency and to reduce costs of domestic industries, thus indirectly helping to expand exports. One policy of the authorities is the denial of quantitative import pro- tection for new products whose domestic selling prices wiould eXceed c.i.f. import prices by more than 25 percent. Application of this policy has been very limited thus far because of business opposition, which has been intensified by the 1971 economic slowdown. In the face of this oppo- sition a second step now being taken is a change in legislation to limit corporate tat exemptions designed to encourage new industries to those which wiould have selling prices within 25 percent of c.i.f. prices of comparable imports or wsould contribute to geographic decentralization. 10. Apart from trying to improve industrial efficiency, the Echeverria Administration is also making a particular effort to develop specific investment projects designed to aid the more rapid development of industry in the poorer zones of Miexico with a favorable resource base. Of prime importance is the large Las Truchas steel project, particularly from the viewpoint of slowiing down the rapid growth of imports which would otherwise occur with the continuation of rapid Mexican economic growth; and various forest industry projects to meet the growth of domestic demand and expand exports. Prospective Bank Industrial Lending 11. The policies and programs of the Echeverria Government have provided a basis for the Bank to become increasingly active in industry, after having made only one loan (for $10 million) specifically for in- dustry in 1952 of which only $30.5 mllion was disbursed because of persistent administrative problems. In recent years the Bank has been providing relatively small amounts of financing for agro-industry as part of livestock and agriculture credit loans. The present "pipeline" includes several forest industry projects, which are at an early stage -4- of preparation and the Las Truchas steel project, which is expected to be ready for consideration by the Executive Directors during FY1973. Under current Mexican plans, external financing for this new steel plant on the Pacific coast would be provided by a combination of Bank, IDB and parallel financing from supplying countries. A major factor in the decision to consider this project was the preliminary indication that its production costs wfould be competitive with imported steel. To help to assure that the plant would be efficiently planned and operated, the Bank and IDB staff have recommended that Mexico contract for a con- sulting and operating advisor. A British firm has recently been selected for this task. As preparation and review of the project proceeds we will be working closely with the MIexicans on the most suitable product lines of the new plant in relation to the existing steel industry. Bank staff have been advising the Government on the creation of a natianal steel policy committee and will be assisting its technical staff in formulating policies and future programs for the integration of existing steel plants and in planning for future expansion of the steel industry. PART III - THE PROJECT Institutional Background 12. The rapid growth of Mexican industry in recent decades has been aided by the existence of a financial sector which is relatively highly advanced among the developing countries. It consists of a mixed system of nearly 200 private and 28 government banks, all of which operate under the rules and regulations determined by the National Banking Commission. iNJacional Financiera (NAFI1), one of the pioneer development banks, is the largest Government bank and the only Government bank that extends long- term credit to industry. The Bank of Mexico, the 45-year old central bank, has a poTwierful role through monetary and credit policy in guiding the flow of funds of the banking system to the various sectors of the econormJ. 13. Banks and financieras (development banks) in general have developed rapidly in an environment of total currency convertibility in which interest rates in Mexico are influenced greatly by interest rate movements abroad. This phenomenon contributed over the years to a competitive outward-looking mentality of the Mexican monetary policy makers and banking community. However, it favored the use of short- term, high-yielding, savings instruments which became the backbone of the spectacular growth of the financieras during the 1960's. The openness of the money markets requires "fine tuning"! of the monetary policy in- struments. It is partly for that reason that the financial system is to a large degree built on short-term resources, resulting in a situation that the average Mexican enterprise has little access to long-term funds at fixed rates of interest. 14. An additional element of i-nportance within the Mexican system is the existence of 10-15 identifiable industrial-financial groups, which dominate the private sector of industry and finance. Therefore, in the case of well-established, large firms, there exists a close relationship with the financial institutions which facilitate their access to financial resources. Loans to finance fixed capital are generally short or medium- term with the expectation that they will be "rolled over". For those firms which do not have this close relationship with a banking group, access to credit on reasonable terms is very limited. It was for this reason that Nacional Financiera,aided by the Inter-American Development Bank (IDB), set up a trust fund to provide loans of up to ten years for small and medium-sized firms. This fund has also received support from USAID. Objectives 15. The project is designed to help to reduce some of lIexico s most pressing problems: the balance of payments deficit, industrial inefficiency, and the lack of long-term industrial finance discussed above. The project's main objectives are to promote industrial effi- ciency and expand industrial capacity by providing long-term loans based on strict project appraisal to a wide range of medium-size enter- prises with growth and export potential. It is the product of a dialogue between Mexico and the Bank which began in 1969 regarding the possi- bility of the Bank's assisting the industrial sector to meet the above objectives. Several Bank missions visited Mexico in 1970 and 1971 to assist in the formulation of a suitable financing scheme. Constitution of FONEI 16. Fondo de Equipamiento Industrial (FO-TEI) waS established on October 15, 1971 by Executive Order of the lanister of Finance, as a trust fund of the Bank of Mexico. Its supervisory body is the Technical Committee. On it are seven members: two representatives of the Bank of Mexico, two of the Finance Ministry (one of whom is the Chairman of the Committee), one of the Ministry of Industry and Commerce, one of Nacional Financiera, and one of the Confederation of Chambers of Industry (CONCIAIIN). FOITEI staff is selected by the Bank of Mexico and is subject to the regulations, salary sbales and fringe benefits applicable to staff of the Bank of Mexico. 17. FONEI will have resources for lending equivalent to $75 million derivedfrom the following sources: $ rmillion Government non-repayable contribution 10 Bank of Mexico : credit for not less than 20 years bearing interest at the rate payable on deposits of financial in- stitu-tions 30 Proposed Bank loan: 35 Total $75 -6- The proceeds of the Bank loan wrill be provided by the Government to FONEI in pesos as permanent capital on which FONTEI will pay interest at 7-1/4 percent and a commitment charge of 3/4 percent. Lending Operations 18. FONEI will operate through public and private industrial credit institutions ("participating intermediaries") selected for their financial soundness and management capability, but will. play an active role itself in appraisal and supervision. Apart from feasibility studies, FONEI will finance only a proportion of the fixed asset costs of eligible projects. Minimum FONEI financing will be $280,000 equivalent to avoid overlapping with the Fund for Small and Medium-Sized Industry. The maximum financing will be $3 million equivalent. The financial intermediary and the final borrower wqould be expected to participate in each FONEI financing operation and the intermediary will be required to provide additional financing from its own resources for working capital. Depending on the type of pro- ject, FONEI would finance a madimum of 72 percent of the total cost of fixed asset financing, and 80 percent of the total cost for feasibility studies. FONEI will charge the intermediary 9 percent interest per year (subject to change in consultation with the Bank, depending on market conditions) and will collect 1 percent per year as a commitment fee on the undisbursed balance of its loans. The intermediary will charge the firal beneficiary 2 percent over the borrowing rate from FOWEI and will also pass the 1 percent annual commitment fee to them. 19. In accordance with its objective of promoting industrial in- vestment with a positive influence on the balance of payments, FONZTEI would finance: (a) export projects, (b) import substitution projects and (c) feasibility studies for such projects. To be eligible for FONEI financing, export projects would have to show a satisfactory positive contribution to foreign exchange earnings and import substitution projects would have to satisfy the tests. set out in paragraph 9 above. Financial intermediaries will be expected to evaluate the financial plan and risk of the project, and to secure adequate collateral before submitting any project to FONEI. They will be encouraged to appraise other than financial aspects of the projects and eventually may be required by FONEI to do so. However, FOUEI will make its oi,m final appraisal, and will supervise the execution of investment plans and projects and the performance of the borrowing enterprise. It will also determine whether the proceeds of its financing have been used for the purposes intended. 20. The Bank would establish a $500,000 equivalent free limit for individual projects, subject to an aggregate limit of $10 million eaui- valent. Thus, the Bank would exercise a close supervision of FONEI's operations. This supervision would extend also to the performance of final borrowers, especially with regard to improved industrial efficiency and export performance, which are the justification of the loan. The proceeds of the proposed loan would not be used to finance the production of consumer goods for import substitution until FONEI and the Bank had agreed on an eligible list of such goods. Nor could any part of the loan be used to finance tourism projects until FONEI and the Bank had agreed on appropriate criteria. -7- 21. The Bank loan wxould be disbursed by FONEI to financial inter- mediaries for projects presented by them and approved by FOINEI. Dis- bursements -ould take place upon presentation of satisfactory documen- tation of the direct foreign exchange cost of the specific industrial project. The financial plan elaborated by FONEI forecasts commitment of the Bank loan within three years. Economic Justification 22. The proposed project is an integrated part of Mexico's efforts to strengthen its balance of payments. It complements a series of fiscal incentives adopted by the Mexican Government for the promotion of manu- factured exports and the modernization of the industrial sector. It is consistent with, and furthers, policies directed toward increasing in- dustrial efficiency. The proposed loan wJill make it possible to finance projects which might otherwise not be undertaken due to the scarcity of long-term industrial financing to medium-size firms in i4exico. The individual projects would, of course, have to show acceptable rates of return in addition to meeting FOINEI's other economic criteria. PART IV - LEGAL INSTRIEINTS AND AUTHORITY 23. The draft Loan Agreement between the Bank and Nacional Financiera, S.A., the draft Guarantee Agreement between the United Mexican States and the Bank, the draft Project Agreement between the Bank and the Banco de MIexico, S.A., the report of the Committee provided for in Article III, Section 4(iii) of the Articles of Agreement, and the text of a resolution approving the proposed loan, are being distributed to the Executive Directors separately. 24. I am satisfied that the proposed loan would comply with the Articles of Agreement of the Bank. PART V - RECOMIENDATION 25. I recommend that the Executive Directors approve the proposed Loan. Robert S. 11c'Namara Attachments President May 10, 1972 Annex I Page 1 MEXICO: uma o Bank Loans - at April 30, 1972 (US$ Millions) Amount less Loan Year Borrower Purpose Cancella- Un- Loan Year Borrower Purpose tions disbursed Toans fully disbursed 759.0 - 450hME 1966 Nacional Financiera, S.A. Irrigation 19.0 1.9 527iME 1968 Nacional Financiera, S.A. Irrigation 25.0 17.2 528-ME 1968 Nacional Financiera, S.A. Roads 27.5 3.9 6594ME 1970. Comision Federal de Electricidad and NAFIN Power 125.0 27.5 695-ME 1970 Nacional Financiera, S.A, Roads 21.8 20.9 74741E 1971 Nacional Financiera, S.A. Agriculture 75.0 62.6 793-ME 1972 Nacional Financiera, S.A. Tourism 22.0 22.0 l/ Total 1,074.3 169.3 of which has been repaid to Bank and othors 230.2 Total now outstanding 844.1 Amount sold: 50.7 of which has been repaid: 46.o 407 Total now held by Bank 839.4 Total undisbursed 156.0 Not yet effective. Annex I Pqgc 2 MlsLICO: Sumnary of IFC Investments at April 3O, 1972 Year EaTi2an Purpose Loan Egait Total ($ MiJJions) 1958/1959 Industrias Perfect Circle, Industrial 0.8 - o.8 S.A. * equiprnent 1958 Bristol de Mexico, S.A. * A/C Engine 0.5 - 0.5 Overhaul 1961 Acero Solar, S.,A. * Twist Drills 0.3 - 0.3 1962/ Compania Fundidora Fierro Steel 2.3 21.4 23.7 5/6/8 y Acero de Monterrey, S.A. 1963 Tubos de Acero de Mexico, S.A. Seamless 0.9 0.1 1.0 steel Pipes 1963 Quimica del Rey, S.A. * Sodium 0.7 - 0.7 Sulphate 1964b1966 Industria del Hierro, S.A. Const. - 2.0 2.0 Equipment 1970 Minera del Norte, S.A. Iron Ore Mining 1.5 - 1.5 1971 Celanese Mexicana, S,A. Textiles 12.0 - 12.0 Total gross commitments 19.0 23.5 42.5 Less cancellations, terminations, repayments and sales 9.0 21.7 30.7 Total commitments now held by IFC 10.0 1.8 11.8 Total undisbursed 2.9 - 2.9 * Investments which have been fully cancelled, terninated, written off, sold, redeemed or repaid are indicated with an asterisk. Annex II Page 1 of 4 MEXICO: COUNTRY DATA SHEET Area: 2 million square kilometers Population: 52 millitn (1971) I. ECONOMIC INDICATORS Calendar Years 1960 1970 1971-R/ (Mex$ billion) GDP 151 423 440 Per capita (in 6urrent US,) 334 668 708 Real growth rates (percent) - 7.7 4.0 Structure of GDP (percent) Agriculture, livestock, forestry 15.9 11. - fisheries Mining 1.5 1.2 - Industry (including petroleum and 20.4 26.0 - petrochemicals) Construction 6.2 5.1 _ Power 1.0 1.5 - Commerce 31-1 30.3 _ General services 20.5 22.0 - Other 3.4 2.5 - Money supply (percent change) - 9.6 _ Prices (percent change) GDP deflator 4 4.8 _ Mexico City wholesale index - 6.0 3.7 Public finances Federal Government: current revenues 11.0 33.6 38.0 current expenditures 7.7 26.9 30.2 current surplus 3.3 6.7 7.8 Federal District (Mexico City): current surplus 0.8 2.1 2.2 Decentralized public sector agencies: current surplus 3.6 5.1 n. a. Total public sector current surplus 7.7 13.9 n.a. a/ Preliminary Annex II Page 2 ef 4 Calendar Years 1960 1970 1971A/ (Mex$ billion) Public finances (cont.) Capital revenues - 1.0 0.9 Pu-blic investment 11.2 27.0 ne Net domestic borrowing 1.7 8.9 n.a. Net external borrowing 1.8 3-2 3-5 Total borrowing 12.1 n.a. Public investment financed out of non-borrowed resources (percent) 69 55 n.'a. Balance of payments (US$ million) Exports of goods and non-factor 1,330 3,012 3,345 services Imports of goods and non-factor -1,481 -3,347 3,h82 services Balance before factor income - 151 - 335 - 144 payments Factor income payments (net) - 160 - 672 - 788 Balance on current account - 311 -1,007 - 932 Private direct investment (net) - 38 352 394 Gross public sector borrowing for 317 932 930 investment b/ Amorti?ation of public sector - 172 - 673 - 538 debts c/ Other capital flows (net), errors 204 396 500 and omissior.s and changes in reserves Public medium- and lonj-term debt Total outstanding (end of period, 842 3,764 n.a including undisbuzsed) a/ Preliminary b/ Public sector accounts figures cl Public sector accounts data. Include short-term loans and loans repayable in local currency. Annex II Page 3 of 4 Calendar Years 1960 1970 1971 (US$ million) Debt service: interest 4 217 207 amortization 172 474 4 Total service 216 691 651 Debt service to IBRD 53.7 59.9 oas percent of total debt service 7.7 9.2 Debt service ratio (percent of exports 16.2 22.9 19.5 of goods and non-factor services) Calendar Years 1950 1960 1965 1970 III. SOCIAL AND RELATED INDICATORS a/ a. Population Birth rate (per 1,000 population) h4.7 h4.6 44.3 44.5 Death rate (per 1,000 population) 15.9 11.2 9.5 9.3 Infant mortality rate (per 1,000 96.2 74.2 60.7 67.2 live births) Life expectancy (years) 48.8 - - 61.8 De.pendency coefficient .9 1.026 - 1.081 Urban population (% of total 42.5 50.7 - 58.5 population) b. EIployment Economically active population - 11.3 - 15.9 (million) Economically active population, by sector: (% of total) Agriculture & mining - 55.0 - 8.0 Manufacturing, public utilities - 18.0 - 23.0 construction Othere - 27.0 - 29.0 c. Public Expenditures on Social Sectors: % of GDP at current market prices - - - 6.7 % of Public sector expenditures - - - 25.0 % of Central Government expenditures - - - 25.0 a/ Values of some indicators are estimated from statistics referring to different years than those in the table. Annex II. Page 4 of 4 Calendar Years 1950 1960 1965 1970 d. Education Functional literacy rate ( 40.0 - - 50.0 of adult population) Primary school enrollment (% of 39.0 - - 70.0 school age population) Primary school retention ratio b/ - 15.0 - 30.6 b/ Graduates over initially enrolled six years earlier. Annex III MEXICO INDUSTRIAJ. EQUIPMENT FUND (FONEI) PROJECT LOAN AND PROJECT SUMMARY Borrower: Nacional Financiera, S.A. Guarantor: United Mexican States Amount: $35 million equivalent. The proposed loan would cover the project's esti- mated foreign exchange component. Terms and Conditions: Payable in 20 years, including three years of grace, at 7-1/4 percent interest per annum. Intermediary: FONEI under the Trusteeship of the Banco de Mexico, S.A. Contractual arrangements between the Trustee and the Borrower will be made for the transfer from the Borrower to FONEI of the proceeds of the loan. FONEI will finance eligible industrial projects through selected financial intermediaries. Project: INDUSTRIAL EQUIPMENT FUND (FONEI) PROJECT Financing of fixed assets of specific industrial projects which will generate foreign exchange earnings or savings through exports or efficient import substitution, and of feasibility studies for such projects. Project Cost: $75 million equivalent, of which $40 million for local expenditures and $35 million for imports. Financing: Government non-repayable contribution $10 million Bank of Mexico credit $10 million IBRD loan $35 million Total $75 ml.lion Procurement: In line with DFC procurement guidelines Limited to Bank member countries and Switzerland. $ million Estimated Disbursements: FY-1972 FY-1973 FY-1974a FY-1975 FY-1976 2.0 8.0 11.0 12.5 1.5 Appraisal Report: DB-91a, May 10, 1972 Annex III MEXICO INDUSTRIAL EQUIPMENT FUND (FONEI) PROJECT LOAN AND PROJECT SUMMARY Borrower: Nacional Financiera, S.A. Guarantor: United Mexican States Amount: $35 million equivalent. The proposed loan would cover the project's esti- mated foreign exchange component. Terms and Conditions: Payable in 20 years, including three years of grace, at 7-1/4 percent interest per annum. Intermediary: FONEI under the Trusteeship of the Banco de Mexico, S.A. Contractual arrangements between the Trustee and the Borrower will be made for the transfer from the Borrower to FONEI of the proceeds of the loan. FONEI will finance eligible industrial projects through selected financial intermediaries. Project: INDUSTRIAL EQUIPM4ENT FUND (FONEI) PROJECT Financing of fixed assets of specific industrial projects which will generate foreign exchange earnings or savings through exports or efficient import substitution, and of feasibility studies for such projects. Project Cost: $75 million equivalent, of which $h0 million for local expenditures and $35 million for imports. Financing: Government non-repayable contribution $10 million Bank of Mexico credit $10 million IBRD loan $35 m-llion Total $75 million Procurement: In line with DFC procurement guidelines Limited to Bank member countries and Switzerland. $ million Estimated Disbursements: FY-1972 FY-1973 FY-197h FY-1975 FY-1976 2.0 8.0 11.0 12.5 1.5 Appraisal Report: DB-91a, May 10, 1972 Annex IV Page 1 EXTRACT FR(li TIE PRESIDEMTS REPORT AUD RE3OI-DAIDATIOUS (1i A PROPOSED LOAUN TO N1ACIGCIAL FIVICIERA, FCR A PORTS PROJECT (P-1036 DATED APRIL 19, 1972.); - 8. *-exico, with a GDP of around -35 billion a year, ranks closely behind Brazil as the Bank's second largest borrower in terms of loans outstanding. Its economy is comparable in size to Brazil and larger than that of any other country to which the Bank Group is lending except India. 1,exico has been remarkably successful in sustaining a 6-7 percent annual growth rate over a period of 15 years, with only a moderate increase in the general price level. This achievement is attributable to a unique combination of historical and geographical factors, intelligent economic and financial policies (exhibiting a high degree of pragmatism and freedom from economic dogma) and a continuity in economic management unparalleled elsewhere in Latin America. Taxation has been kept low (around 9 percent of GDP), but private savings have been encouraged, and a considerable prOportion of these savings has been channelled into the public sector thirough the banking system. Iational savings have been maintained at close to one-fifth of GDP, and although there has been a significant increase in the extermal deficit on current account since 1968, this still constitutes less than 3 percent of GDP. 9. There is another side of the picture to which attention has been dratrn in my previous reports on iexico. Of all countries in the world uith populations of comparable size, 1.exico has the fastest demogra- phic growth rate. `-Bhile per capita income at current prices has risen from `200-250 a year in the middle 1950's to about 4700 a year today, the increase in income has been very unevenly distributed. iJhile organized workers and the grow-ing middle class have shared in the benefits of economic development and a few people have become very rich, relatively little has been done to alleviate rural poverty. Some 40 percent of the population still depends on agriculture for a living, but agriculture accounts for only 11 or 12 percent of the national income. itithin the aCricultural sector itself there is a sharp contrast betweel the prosper- ous conditions of the larger private farms, particularly in the irrigated north and along the coast of the Gulf of iiexico, and the desperate poverty of the small farmers in the central plateau and along the central and south Pacific Coast. Rural edtucation and healtlh have not been given much at- tention; and away from the maini roads, communications in most parts of the country are still quite primitive. 10. The Administration of President Echeverria, wihich took office at the end of 1970, has laid great stress on the need to improve the conditions of the poor and to correct inequalities in income. At the same time, how- ever, the Government has been forced to recognize the ccnstraints imposed on the gro,wth of the economy by the w-jidening gap betueen imports and ex- ports and the increasing external debt which has kept the debt service ratio above 20 percent in recent years. First priority has accordingly been given to changes in economic policy and improvements in economic managerment required to maintain a satisfactory overall growth. As noted in mny last report on 1iexico, a series of newi tax measures wzas enacted in Annex IV Page 2 late 1970, sugar prices w7ere increased, and steps were taken to strengthen central control of public borrowing. At the same time, neax emphasis was given to export promotion, and a scheme was introduced under which manu- factured exports are entitled to tax rebates up to 10 percent of export value. A second fiscal package was adopted early this year, including a neti tax on income froma fixed-interest securities, an increase in mar- ginal rates of personal income tax and tax incentives for industrial in- vestment. There is also a ner tax, equivalent to 5 percent of enter- prise payrolls, the proceeds of which are to be used to finance workers' housing through a .;ational H-lousing Fund. The two tax paclcages together, excluding the housing tax, are expected to increase federal tax revenues by about 10 percent and should raise the ratio of taxes to GDP by approxi- mately one percentage point. 11. Public investment was deliberately held down in 1971 to protect the balance of payments, and this was one reason why the real growth of GDP slowed do-mr to 3 or 4 percent, producing something of a recession from uhich industry may now be slowly recovering. On the more positive side, there appears to have been a net reduction in medium and long-term ex- ternal public indebtedness during 1971, mnade possible in part by a small improvement in the current balance of paymLents, but more importantly by a large inflowi of short-term finds. Intermational reserves increased by y200 million during the year and now- stand at well over 4 billion. 12. Improved external debt management has been reflected in the terms on which the .exican auttorities borrowed in international capital markcets during 1971. For example, loans with maturities of 1 - 5 years, mi. ch accounted for over 40 percent of total external public borrowi.ng in 1970, rmde up only 12 percent of such borrowing during the first 9 months of last year. Tuo major operations concluded with consortia of foreign banks for a total of ,220 million carry final maturities of 8 and 10 years from signing, with a grace period of 4 years in each case. The public issue of D.100 million in Gennany in Iovember 1971 had a term of 15 years, including 5 years o2 grace. Another issue of 9'40 million, marketed in leu York. a short tile ago has a term of 15 years. This im- provement in the terms of borrowing from private sources iill makle it easier for Iiexico to support a continued high rate of economic expansion without endangering its credit standing abroad. There is, however, little prospect of the country obtaining all the external capital it needs on extended terms without substantial contributions from the IBRD and the ID13 which axe the only official lending agencies in a position to offer development assistance o, nion-commercial terms. 13. Public savings in !exico must also be increased if expenditures on rural development and social services are to be raised to more adequate levels, and this has been a constant theme of the Banlkts economic reports. As a result of the tax measures already described, there does appear to have been some increase in federal government savings during 1971, and the savings of the Federal District also improved slightly. On the other hand, there has been a decline in the total savings of the three major public enterprises (the national petroleum company, the federal parer com- mission and the railroads) from iiex.3 billion in 1970 to laex9'2.1 billion in 1971, and this trend needs to be reversed - a matter of special concern to the Bank in view of the proposed loans for railuays and power. Annex IV Page 3 14. The primary objective of Bank lending to .-Nxico has always been to support the grotwth of the econony by providing long-temn capital for projects that can both benefit from the Bank's special expertise and promise high developmental returns. At the same time, in the case of the power program and the steel project now under consideration, both of itich have large import components, Banlc participation helps lifexico to organize financing from other sources on the basis of broad international competitive bidding. The Banlc has been associated vith the power sector since 194c, and while the federal parer cornission, with the BankIs encouragement, noxi looits to export credits to meet a significant propor- tion of its extemal capital requirements under joint or parallel fin- ancing arrangerents, the .exican authorities attach great importance to a continuation of Bank lending for power, particularly for financing the foreign exchange costs of civil works and equipment for transmission and distribution. The !Lexican Government has also sought the Bank's financial and technical assistance for the development of the transport sector, initially mainly for roads, but since the 1970 sector study, for ports and raili!ayrs as well. 15. Powser and transport apart, the Bankl is giving special emphasis to projects uhich directly help to strengthen the balance of payments, since the balan-lo of payments is liable to be a critical constraint on economic deve.lo,ment in an econonr tied to free convertibility of its currency and heavily dependent at the margin on private capital inflow. hlis has been an important- consideration in past lending for irrigation (cotton) and tourism and in the lending noE proposed for a news industrial fund. Additionally, now tlhat it is the declared policy of the .exJican Government to give more attiention to the quality of economic develop- ment, especially in rural areas, the Dank is interested in giving what support it can to programs for education and rural development, and a considerable amount of staff time is currently being devoted to the identification of possible projects in these two sectors. HIowever, the capital expenditures Livolved are li1kely to be quite small. Finally, in view of the great potential scarcity of water in hTexico, plans are going ahead for a national water stutr to be carried out waith the Bank's help, possibly with some financing froir the UUIDP, and a project for the supply of water to liexico City and adjacent urban areas is scheduled for appraisal shortly. 16. The choice of 3ank projects in ;.exico is naturally governed to an ixiportant extent by the priorities of the Liexican Government and by the availability of financing froma other sources. Since in the past the Inter-American Development 3anlk has been able to provide soft loans for projects of a social character, and has also been more liberal in financinig local costs, Lexico has sought its assistance in preference to that of the I3TD for such projects as feeder roads and minor irrigation works. hle main contribution to the extemal financingj of industrial development in `exico has come frol e:xport credit agencies and private sources. 0ver the period 1966-70, the 3ank accoi.uħted for 11 percent of the flow of medium and long-term capital to Lexico and the TDB for 5 per- cent. Tihese proportions are like4l to be siCnificantly h-igher in future Annex IV Page 4 in conformity lith the ilexican Government's aim of improving its external debt structure, but the greater part of the capital which i!exico requires from abroad will continue to come from private financial institutions and export credit agencies. "